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As QE in Europe ends, liquidity risks could stoke debt market volatility

Increasing volatility is expected to be a pervasive theme across European debt markets in 2019 as the European Central Bank ends its multiyear bond-buying program, removing a source of demand upon which debt markets have come to rely.

Having started quantitative easing in March 2015, the ECB confirmed Dec. 13 that it will end QE after buying €2.6 trillion of European debt — primarily government bonds — and swelling its balance sheet to 40% of eurozone GDP from 14% in 2007, according to a report by S&P Global Ratings.

The ECB will cease additional asset purchases at the beginning of 2019 but will continue to reinvest the proceeds of the maturing debt purchased during the program to maintain a source of liquidity.

Periphery political jolts

As a result of the extra liquidity, yields on European sovereign debt have been restrained even as the European Union lurches from one market-spooking political event to another.

"This looks to be a year where European markets will continue to be exposed to political shocks, and more generally to an increasing bearish sentiment worldwide," said Angel Talavera, lead eurozone economist at Oxford Economics, in an email.

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ECB President Mario Draghi, while planning to end additional asset purchases in early 2019, will continue reinvesting proceeds from previous bond purchases.

Source: Associated Press

All this is happening as "the ECB is shrinking the safety net and makes markets more reactive to political risks," said Mauricio Vargas, senior economist at Union Investment, a Germany-based asset manager overseeing a €332 billion fund.

Simona Gambarini, a markets economist at Capital Economics, said the end of QE will have a limited impact without other factors to scare away investors. "We think that bond yields will rise only slowly after the end of the ECB’s QE. The biggest increases are likely to come from the periphery, with Italy most at risk of a sharp selloff," she said.

Yields on 10-year Italian bonds soared in the wake of the country's populist government confronting the European Commission over its plans to increase its fiscal deficit. Concerns over the potential further downgrades of Italy by rating agencies have sparked fears among some investors, given that the ECB is not allowed to buy assets with junk status. "Without the support of the ECB, you might risk the solvency of Italy," Vargas said.

It could also mean shifting market dynamics. "For the first time in years, price-sensitive private buyers will determine where Italian government bonds trade and, ultimately, whether the country's €2.3 trillion debt pile — the third-largest in the developed world — is sustainable," wrote Andrea Delitala, head of multi-asset euro, and Steve Donzé, senior macro strategist, at Pictet Asset Management.

Pictet notes that the private sector will have to absorb €57 billion of Italian government bonds in 2019, up from €11 billion in 2018 and negative €54 billion in 2017 as the private sector sold its exposure to Italian government debt.

But yields on 10-year Italian bonds, or BTPs, have fallen sharply from a peak of 3.67% on Oct. 18, to 2.93% as of 3:50 p.m GMT on Dec. 13 as the Italian government suggested it may scale back its deficit target, well short of the 4% level that Pictet calculates would be unsustainable.

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ECB normalization

In terms of "normalizing" policy to end asset purchases, the ECB is a long way behind the U.S. Federal Reserve, which is reducing the size of its balance sheet by $50 billion a month, a move that has been linked to rising yields in the U.S. bond market.

"The ECB will likely prefer to wait and see how the [bond] repayments affect financing conditions before it starts reducing its bond portfolio," Marion Amiot, S&P Global Ratings senior economist, wrote, noting, "we expect the ECB to stop reinvesting all of the maturing bonds from mid-2021."

How the ECB chooses to reinvest its portfolio could be crucial, according to investors who warn that liquidity will vary from asset to asset. "We thought [German] bund yields would have moved 50 basis points higher in a year like this. The demand for a euro risk-off asset has been high this year with the events in Italy in particular, but also the weak performance of the German economy was noteworthy," said Mark Holman, CEO, partner and portfolio manager at TwentyFour AM.

The yield on the 10-year bund was 0.27% on Dec. 13, four basis points lower than a year earlier, as investors sold French debt after the government unveiled a new spending plan that could breach EU rules, and sought sanctuary in Germany. But Holman expects demand for German bonds will weaken, even as political risks remain elsewhere in Europe. "We find it hard to reconcile fundamentals with a yield of just 0.25% on the 10-year," he said.